Page 106 - DCOM206_COST_ACCOUNTING_II

Unit 5: Differential Costing

(b) If we are going for shut down, whether the closure should be permanent or temporary. Notes
Shutdown decisions often involve long term considerations, capital expenditures and
revenues.
(c) A shutdown should result in savings in annual operating costs in future.



Case Study Make or Buy

n this period of tight budgets, many governments are under increasing pressure to do
more with less. One potential way to reduce costs is to outsource services to private
Ifirms, non-profit organisations, or other governments that can provide the services
more efficiently. In some cases, outsourcing can result in significant cost savings over the
long run. In other cases, however, outsourcing may actually end up increasing a
government’s total costs. How can a government know whether outsourcing a given
service will result in a cost savings or a cost increase? This article answers this question by
demonstrating how to perform a cost analysis. The decision as to whether to perform a
service “in house” or outsource it to an external provider is commonly referred to as the
“make-versus-buy” decision. This article walks through the steps involved in a make-
versus-buy cost analysis. But first, two key points warrant emphasis: (1) a make-versus-
buy cost analysis should use a differential cost perspective and (2) the analysis should
cover a multi-year period and discount future cash flows to their present value.

Use a Differential Cost Perspective
Differential cost is the key cost concept for evaluating the outsourcing of a service. The
differential cost shows how a decision to outsource will change a government’s costs. It is
crucial to look at the differential costs instead of merely comparing the total costs of the
status quo to the total costs of using a private contractor. The pitfall of comparing total
costs is that they may include fixed costs that cannot be avoided by outsourcing a service.
This could give the appearance that a government will incur fewer costs by using a private
contractor when it actually will incur more. For example, let’s say that a private waste
hauler offers to provide waste collection services to the City of Unionsville for $550,000
per year. As it stands, the total cost of providing waste collection services is $750,000 per
year. Thus, it appears that the city could save $200,000 per year by hiring the private
hauler. However, a closer look at the city’s fixed costs reveals that it is committed to
spending much of the $750,000 whether or not it switches to a private hauler. More than
half of this amount is personnel costs, which the city cannot avoid because of a “no-layoff”
policy and the fact that the truck drivers perform other responsibilities. Likewise, the city
is committed to $50,000 per year in debt service payments for the facilities used to store
and maintain its garbage trucks.

Sunk Costs: A potential mistake in a make-versus-buy cost analysis is the inclusion of
sunk costs. A sunk cost is a cost that has already occurred and will remain the same
regardless of what decision is made. As such, sunk costs should be ignored in a cost
analysis. To see how including sunk costs can lead to bad decisions, suppose a county
government is considering outsourcing its warehouse function to private suppliers that
can maintain inventories of all the county’s supplies and ship them overnight. One year
earlier, the county had spent $500,000 for a consultant to develop a state-of-the-art inventory
process. Opponents of the outsourcing plan argue that the county should not outsource the
warehouse function because it just poured $500,000 into perfecting the existing system.
However, this $500,000 should not influence the decision because it cannot be recovered
Contd...

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